Return of the Prodigal Economy

42,000 years ago the magnetic poles of the Earth reversed, causing a hugely destabilizing climate disaster. The event provoked a series of environmental shocks that today could only be captured by the most wildly imaginative Hollywood director – chaotic weather patterns, a smashing of the ozone layer, intimidatingly large ice sheets and ripping solar winds.

By analyzing the rings of New Zealand swamp kauri trees scientists have modelled some of the conditions and potential side-effects of this jolt to the Earth’s magnetic field (https://science.sciencemag.org/content/371/6531/811). For instance, Neanderthals and many large species were wiped out and humans would likely have sought shelter in caves.

Though this fascinating story tallies with my recent Mars focused missive, it maybe strangely, had me thinking about the bond market. In many ways, the bond market is the magnetic field of the financial system – when it is destabilised, other markets and broad economies suffer.

Its financial and economic power is legendary, so much so that when something happens in the bond market commentators dust off quotes about ‘bond vigilantes’ or James Carville’s (political adviser to Bill Clinton) that if reincarnated he would like to return ‘as the bond market …because you can intimidate everybody’.

The bond market has largely been dormant for much of the past ten years, because inflation has been feeble and central banks have continued to hoover up the supply of bonds. Some issues, such as Austrian 100-year bonds have been stellar performers, but in the course of the past month have fallen by over 20%, a shock to the risk averse type of investors who hold these instruments.

More importantly, the US 10-year bond yield – the lynchpin of the global system – rose from 1% at the end of February to 1.63% this week, a move that is historically rapid and significantly large, even if yield levels are still low. Contrast the ECB’s odd comment that it was ‘monitoring’ yield moves even though many euro zone bond yields are negative, with the advice textbooks (up till 2010) gave that 3.5% was a good benchmark for the 10-year yield.

The move in bonds is significant in at least four respects. First, it has checked the dizzying ride higher in equity and credit markets and in the near future should make these markets more two sided. In particular technology stocks whose valuation multiples are sensitive to the level of yields have suffered while banks, whose business model is bolstered by higher yields, have done well.

Secondly, the rise in yields is a mini revolt of sorts against central bank policy. Third, it reminds us that should interest rates rise further, the colossal load of debt that hangs over the world economy could become existentially dangerous.

So far what has been interesting is that while bond yields (even adjusted for inflation expectations, or real yields) have risen, credit risk has been very well behaved. Should the level of bond yields rise further (to 1.65% and above for the US 10 yr) then this will create problems for leveraged investors and leveraged companies.

The fourth germane point is inflation. Like a long-lost friend, we haven’t seen inflation in quite some time – or so headline inflation indicators tell us (consumer price inflation in the USA is 1.3%). Many people forecast that with a triple whammy of the ‘end of COVID’, huge stimulus packages and easy central bank monetary policy we will see a surge in spending and therefore inflation (notwithstanding the taming effects that demographics and technology have on inflation).  

For the moment inflation is everywhere, except in the official inflation figures (it is beginning to show up in producer prices though). Inflation expectations, as measured by markets are high and rising however (close to 2.5%) and there is a generalized sense that inflation has been redirected into asset prices rather than consumer goods.

This phenomenon is more easily understood if we consider that survey’s report that half of 25–34 year-old Americans plan to put the money from their stimulus checks into the stock market. Treasury Secretary Yellen has been largely silent on this though I can’t imagine that any of her close academic economist friends from Joe Stiglitz to her husband George Akerlof would regard this use of ‘stimmy’ checks as economically productive. To that end, Yellen might surprise us by introducing some sort of transaction tax or tweak to capital gains, or more simply try to prompt changes in margin requirements.

The other pressing issue is how central banks will react to both rising yields and the likelihood that inflation is finally materializing. An overt reaction to yields in the shape of a ‘yield curve control’ policy (keep long duration bond yields low) would likely set off a powerful rally in technology stocks. What is more likely is that central bankers will ‘whistle past the graveyard’ of inflation in the sense of publicly denying its existence, though privately fearing that eventuality. If we were to get an inflation shock, small and momentary as it might be, then central bankers may have to maneuver into a very difficult policy change.  

This may be some way off. However, the ‘prodigal’ phenomenon of higher bond yields is here to stay especially if the velocity of money picks up. Like a jolt to the magnetic pole of the Earth, this new market regime will have wide ranging implications. With debt, stocks and housing all expensive, a breach higher in yields might have us all living in caves too.

Have a great week ahead

Mike

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